American novelist and short-story author Henry Miller once wrote, “Chaos is the score upon which reality is written.”
It seems pretty accurate considering how often chaos hits.
Sometimes it’s in the simple, everyday form of traffic or a toddler wrecking every room. (After surviving five of them, I’m well-versed in how that happens.) Sometimes it’s a personal crisis like a divorce or unexpected unemployment.
And sometimes it’s a day – or days – where the entire investment market seems to capsize.
No matter how often chaos happens though, it has a very good track record of throwing us off kilter. So I don’t blame you one bit if this week’s volatility is leaving you unsettled… or worse.
But I want to stress that you can find peace in this chaotic reality we find ourselves in. That’s why I wrote yesterday’s piece about the power of repeatability:
I first learned about it while reading Repeatability: Build Enduring Business for a World of Constant Change. Written by Chris Zoon and James Allen, it’s one of the best books I’ve ever read, explaining how:
Most of the businesses… with the longest continuous lives stayed entirely focused on a specific niche that had evolved gradually since the company’s founding around a relatively simple original model.
In short, when businesses keep it simple in terms of their mission, they can weather the chaos whenever and however it strikes. They don’t have a million parts moving in completely different ways that keep them distracted in every direction.
They know what’s important and how to protect it with wide business moats that keep the competition at bay.
Today, I want to delve into what those moats can look like so you’re better prepared to take part in that protection. While the markets rage around us, you can rest assured that your holdings are as safe as they can be.
It’s one of the best ways to get through volatility with your profits – and your sanity – intact.
Wide-Moat Advantage No. 1: Intangible Assets
Intangible assets like patents, licenses, and regulatory approvals might not have physical heft to them, but don’t underestimate them. A company that has that kind of paperwork can slow the competition significantly, if not stop it altogether.
Take the pharmaceutical industry with its patent-protected, brand-name drugs. While generic competitors eventually can get their own versions to market, they have to wait seven to 12 years.
That’s more than enough time to give Big Pharma massive returns and room to bring the next blockbuster drug to market.
Plus, it’s not as if they lose everything as soon as the “cheap stuff” is available. Many patients are used to the original products by then and don’t ever make the switch.
They trust the tried-and-true company, which is another type of intangible asset altogether: the power of a good brand name. Entire businesses exist on their appeal to the elite: Tiffany, Prada, Louis Vuitton…
They promise prestige to their clientele, who often live for that kind of status.
Less extreme examples of this are companies like Nike (NKE) – which runs on celebrity endorsements – or Apple (AAPL), which campaigned brilliantly on being the “cool” choice. In fact, Warren Buffett credited his AAPL investment to his realization that Apple wasn’t just a tech company, but a strong consumer brand with an extremely loyal customer base.
Or, on the food side, there’s Oreo. Are you really going to be able to enjoy your cookie sandwich quite so much by any other brand?
Whether it’s Coca-Cola (KO) or Cheerios, it’s hard for consumers to turn away from their favorite products by their favorite companies. And all that advertising you see for them just keeps those customers coming back.
Wide-Moat Advantage No. 2: Cost Advantage
Then again, there are also entire companies built around offering cheaper options. Firms that can provide goods or services at better prices than their rivals have an automatic and obvious advantage.
One of the biggest, of course, is Walmart (WMT).
On the one hand, yes, its one-stop-shopping appeal is hard to beat in and of itself. But it also boasts such high production volumes that it’s able to reduce manufacturing costs, allowing it to offer customers often very competitive pricing.
(And even when it doesn’t, its reputation for offering lower prices works like a charm.)
Walmart has long since attracted bargain and lower-income shoppers. But that appeal rises intensely when the economy weakens. We’ve seen its bottom line growing against its more expensive competitor, Target (TGT), ever since inflationary forces began.
Better yet, many of those customers will stay long after prices settle just because Walmart is now part of their shopping routine.
Wide-Moat Advantage No. 3: Switching Costs
Another popular wide-moat model is to build your business around switching costs. Perhaps you know this method better as the “razor and blades” approach.
The company in question sells the initial razor for a wonderfully low price that might even lose them money. But then it more than makes up for this loss leader by overcharging on the razors, knowing the likelihood – or lack thereof – that customers will walk away once they have the initial product.
One excellent example of this is Apple. (Hey, nobody said you can’t have more than one moat.) Once you’ve purchased one of its products, you’re automatically part of its ecosystem.
And once you are part of its ecosystem, it’s very easy to buy even more Apple products and extremely difficult to buy anything else.
Trust me. I know.
Anyone who’s used an iMac knows how perfectly it syncs up with your iPad and iPhone. They also know how unique the user experience is, with different key placements, menu layouts, and visuals.
Once you get used to them, it’s utterly irritating to switch to anything else.
Or how about an HR software provider like Workday (WDAY). When firms buy its products, they train every employee on how to use them. Moreover, Workday software is made to integrate into a wide range of corporate tasks.
So once it’s implemented, it’s more often than not a waste of time, money, and resources to try out competing products.
Wide-Moat Advantage No. 4: Network Effect
One of the most durable types of moats without a shadow of a doubt is the network effect. Though this protection often can’t come until some other moat is established.
Rooted in a business operation’s scale – or size – the network effect is essentially a “bigger is better” setup. The more customers a company can get, the more necessary it becomes.
One excellent example of this setup is Visa (V), which consumers use the world over. Billions and billions of them, in fact. It’s the most popular credit-card name out there by far.
This makes it virtually impossible for stores not to accept Visa. And the further society moves away from cash, the more important this brand name becomes.
Google is another prime example. While it may have taken years for it to build up its size, that size is now an advertising campaign in and of itself.
Ask yourself this: How do you tell people to search for something online? You tell them to “Google” it, prompting people to go right to that site over Bing, Yahoo, or any other alternative.
It’s difficult to beat that kind of network.
Wide-Moat Advantage No. 5: Efficient Scale
Last but not least, we have the wide-moat power of an efficient scale.
Most Western countries don’t allow monopolies anymore in most circumstances. But there are plenty of duopolies or triopolies out there to select from.
And that is essentially what I’m referring to here.
This is naturally most pronounced in niche industries that are difficult to get into, such as aircraft manufacturing. Boeing (BA) and Airbus dominate this category, offering necessary products and services that require intense technical know-how.
That’s one aspect that makes it more difficult for new competitors to rise up. But then you also have the cost component, where it’s not cheap or easy to make a plane.
This applies just as well to railroad companies like Union Pacific (UNP). The upfront infrastructure costs of getting involved in this industry are enormous, with no guarantees of that investment paying off.
On top of that, the market is too small and contained to sustain much more competition than it already has. Therefore, existing players are left in a sweet spot, unmolested by normal market forces.
One Final Wide-Moat Word
When you find an investment with a solid economic moat, think twice before you pass it over.
I’m not saying it should be an automatic buy, mind you. There are other factors to consider, including whether it’s trading at a discount and whether it fits into your particular portfolio to meet your specific goals.
Just know that, if it is well-priced and will complement your other investments… there are few better stocks to hold onto during volatile times. Their shares might bounce around with everything else, but their shareholders can rest easy knowing the downturn is almost certainly temporary.
I know it’s disconcerting to watch any stock drop. But now is not the time to panic – not when you have a strong portfolio filled with wide-moat positions.
Regards,
Brad Thomas
Editor, Wide Moat Daily
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